Mumbai: After outperforming their overseas peers this year, Indian equity markets might lose some sheen in 2011 as other emerging markets with cheaper valuations attract a larger share of fund flows, equity strategists say.

Relatively expensive valuations—the Sensex is trading at 19 times its forward earnings against an historical average of 17 times over the past five years—and upside risk to inflationary pressure arising out of rising commodity prices that can limit earnings growth have led analysts to suggest that other markets might be more attractive.

Indian equity markets have always traded at a premium to their peers, with the premium widening to nearly 30% over the MSCI Emerging Markets Index in 2010 against an average premium of 20% over the past five years.

Analysts are betting that 2011 could see the premium narrowing as underperforming emerging markets play catch-up and attract higher fund flows relative to their size.

India’s growth story justifies a premium, but that is largely priced in at current valuations, most analysts say.

An economy estimated to grow 8.5% in the fiscal ending next March—behind only China among major economies —and robust corporate earnings that are set to increase by 20% have helped Indian equity markets attract record foreign institutional investor inflows worth $28 billion (Rs 1.26 trillion) this year.

The 30-stock Sensex has outperformed the MSCI Emerging Markets Index by 6% in dollar terms so far, and outshone its Bric peers (Brazil, China, Russia, India) as the domestic consumption theme struck the right chord among a large section of investors wary of economic uncertainties in other parts of the globe.

India would continue to receive its fair share of global funds even in 2011, but it might not get a disproportionately large share of flows that it received this year in anticipation of quantitative easing measures in the US, said Sanjeev Prasad, analyst at Kotak Institutional Equities Research in a 17 November note to clients.

While India and Indonesia attracted fund flows from investors across the globe this year on account of their domestic consumption led growth, export-oriented markets such as South Korea and Taiwan, where valuations are more attractive, might offer better returns as global recovery picks up pace, Credit Suisse AG Asia-Pacific strategist Sakthi Siva said while launching a report on the Swiss bank’s equity outlook for 2011.

Credit Suisse expects Asian equities to offer returns of 20% in 2011 and the Sensex to underperform with a rise of 8.5% to a level of 21,650 in December 2011.

Citigroup analysts project a Sensex target of 22,000 for December 2011, indicating an upside of around 10% from current levels against a projection of 22% returns from Asia.

Kotak has put a six-month Sensex target of 21,000 in its 17 November strategy note, saying that valuations are already factoring in earnings for the fiscal year ending March 2011. The Sensex trades at nearly 16 times its forward earnings for fiscal year 2012.

To be sure, the view that other Asian economies might do better is not unanimous though and predicated on the belief that global growth does not falter and trade between economies increase and export-oriented economies outpace others.

Indeed, a steady recovery in global growth or even a perception of a steady recovery might be at best a mixed blessing for Indian markets as it would spike up commodity prices, pushing inflation up, inducing interest rate hikes and exacerbating cost pressures for the manufacturing sector, which remains a net importer of commodities.

On the flip side, a deep risk-aversion event on the global front could slow down India’s growth and cause markets to react adversely, argues Ridham Desai, managing director of Morgan Stanley India Co. Pvt. Ltd in his India strategy note.

“India’s best-case outcome is a muddle-through world", Desai writes in his note. Forecasts for global growth vary between 3-4% among analysts who have so far published their outlook reports. The International Monetary Fund has projected the world economy to grow by 4.2% in its October World Economic Outlook report after estimated growth of 4.8% in 2010.

“We foresee a sluggish Western recovery alongside growth in the East that might be slower than in 2010, but which is solid and sustainable", Gerald Lyons, chief economist at Standard Chartered Bank Plc wrote, in his 29 November global outlook report.

Relatively stronger economic performance and expectations of currency appreciation make emerging markets an attractive destination for investments. However, most analysts seem to be betting on the underperformers within emerging markets as well as underperforming sectors to offer higher returns in the year to come.

In the Indian markets, investors look set to focus more on corporate investment than domestic consumption, with analysts projecting a rebound in the capital expenditure cycle that would lead to a change in the fortunes of infrastructure and capital goods sectors.

Challenges in the execution of infrastructure projects, however, remain a key issue and policy initiatives to tackle them might act as an upside trigger for the market.

Within consumption, the focus seems to be shifting from consumer staples to discretionary consumption.

Some such as Citigroup and Credit Suisse expect telecom —an underperformer for most of 2010—to deliver higher returns next year in the belief that the worst is over for the sector. Real estate might continue to be unattractive as bank loans for the sector slow.